Scope 3 Emissions: Seeking Clarity in a Sea of Uncertainty

By Kenneth Grant, Managing Director, Energy Policy and Regulation, Berkeley Research Group and Carlos Pareja, Vice President, Internal Audit, Capital Planning, Morgan Stanley

Background

It is commonly recognized that Scope 3 emissions represent the majority of emissions for most companies. Unsurprisingly, investors and regulatory authorities continue to advocate for the inclusion of corporate financial disclosures relating to greenhouse gas (GHG) emissions that arise from the goods and services acquired to produce their outputs (upstream) and as a consequence of the use of their products (downstream). Yet corporate financial officers (CFOs) face two dilemmas: 1) the methodological and operational challenges of determining the emission of GHGs outside of the company’s control; and 2) the absence of regulatory clarity as to how they are to be disclosed, with multiple frameworks proffering guidance. And these challenges omit the assurance, verification, and enforcement structure required but yet to be built.

Consequently, CFOs face new emission-reporting responsibilities and risks.

The Transition

In the midst of the call for “more detailed, consistent, reliable, and comparable information” of firm-specific, climate-related impacts, risks, and opportunities, multiple parties have developed frameworks offering guidance as to how such information is to be estimated, including the Greenhouse Gas Protocol, CDP, Global Reporting Initiative, Transition Plan Task Force, and Taskforce on Nature-related Financial Disclosures (TNFD), as well as the IFRS.

However, the profusion of such frameworks, with their diverse guidance as to the data and methodologies that may or should be employed in calculating, estimating, and reporting Scope 3 emissions, runs contrary to investors’ needs for transparency, consistency, and comparability.

Fortunately for CFOs, the IFRS has been actively seeking to reduce the complexity of the reporting process, including for Scope 3 emissions, by entering into strategic relationships with regulatory authorities and framework providers. The agreements with regulators intend to improve the clarity of the reporting process by harmonizing the information to be disclosed. The agreements with framework providers seek to simplify the data collection and reporting process through the development of a common understanding of how the various frameworks map against each other and the reporting requirements put forth by the regulatory bodies.

Yet gaps remain. For example, the IFRS Climate-Related Disclosures Standard (aka IFRS S2 standard) allows for relief in reporting Scope 3 emissions where an enterprise determines it impracticable to do so. In contrast, the EU’s regulation on corporate sustainability disclosures (EU CRSD) provides for no such relief.

While the EU CRSD takes no position on the accuracy or precision of the current state of Scope 3 data, the uncertainty of estimating these emissions is evidenced by the range of approaches that may be employed when such information cannot, with “reasonable efforts,” be collected directly. These include “data from indirect sources,” “sector-average data,” “sample analyses,” “market and peer-groups,” “scenario or sensitivity analysis,” “spend-based data,” or “other proxies.”

In short, the situation imposes a heavy burden on CFOs: how is a company to report what is difficult to measure, not yet fully defined, and requires choosing among potentially dissimilar options?

The Role of the CFO

The recent enactment of the EU’s sustainability disclosure requirements sets a landmark precedent and will provide insight for regulatory authorities, reporting enterprises, investors, and civil society organizations to agree on methodologies for reporting Scope 3 emissions information in a way that that meets the needs of the capital markets.

But this will take time. During this period of regulatory adjustment, reporting enterprises remain responsible for meeting evolving reporting requirements. The following practices can serve to mitigate risks that must be managed by CFOs and controllers that are instrumental in such a transition:

1. Maintain general ledger flexibility, including managerial information availability and reliability
2. Build processes to identify and assess materiality of climate-related risks, including Scope 3 emissions, and key assumptions employed in and limitations of those assessments
3. Assess the quality of the data—both internal and that acquired from third-party vendors—employed in meeting reporting requirements
4. Document processes and data transformation employed to generate climate-related information, including Scope 3 emissions
5. Establish independent validation mechanisms to challenge emissions-related processes, methodologies, and outputs, including estimated financial impacts
6. Benchmark the enterprise’s results against similar enterprises and/or industries
7. Ensure consistency with the type of assurance acceptable to IFRS and US Generally Accepted Accounting Principles (GAAP) in the reporting of GHG emissions’ CSRD metrics and criteria
8. Develop a governance program that involves and informs senior corporate management, including the audit committee and board of directors, on proposed methodologies and key concerns from external and internal auditing required for the production of climate-related disclosures.

Conclusion

The EU’s CRSD begins the transition to the formal development of regulatory and accounting standards for the reporting of Scope 3 emissions-related financial and operational impacts. Given the complexity and uncertainty associated with the measurement of Scope 3 GHG emissions, the transition inevitably will present challenges for CFOs. Regulators, investors, and boards of directors will analyze the provided disclosures, with the CFOs caught between calls for greater transparency, methodological alignment, and the need to protect commercially sensitive information. We believe, however, the CFO can take actions that will enhance the robustness of the information sought by investors while mitigating the regulatory ambiguity inherent in the transition.

Carlos Pareja, Vice President, Internal Audit, Capital Planning, Morgan Stanley

Kenneth Grant, Managing Director, Energy Policy and Regulation, Berkeley Research Group

Kenneth Grant, Managing Director, Energy Policy and Regulation, Berkeley Research Group

Carlos Pareja, Vice President, Internal Audit, Capital Planning, Morgan Stanley

The opinions expressed are those of the authors and do not necessarily reflect the views of the organizations, their clients or [Publisher], or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.